The More Things Change….
MBS prepayments very stable in spite of Fed action
By Jim Reber
Community bankers, being conservative types (regarding their investment strategies, among other topics), like predictability. Equity markets, commodities, and the dreaded “D” word (“derivatives”) all are perceived by many to be far too volatile for their risk profile, whether we’re talking about personal or commercial investing. I would hasten to mention that risk aversion has served the community banking industry very well over time.
This brings us to this column’s topic. It’s been well documented that mortgage-backed securities (MBSs) are very popular with investment managers. Currently, over half of all community bank investments are of the amortizing variety. Virtually all of these are issued or guaranteed by the government or its agencies, so the credit quality is very high. With interest rates rising, a lot of the high premium prices of the last decade have dwindled, so that risk has pretty much abated. The corollary risk to rising rates (other than prices falling, of course) is that cash flow dries up.
Different this time?
So far in this cycle, however, prepayment speeds haven’t shut down. It’s true that they’ve slowed, but most moderately-seasoned MBSs are still paying down at about the same pace as a year ago. And let us be reminded that that Fed has hiked overnight rates 75 basis points (0.75%) during this time. What’s going on?
There are really several forces at play here. As the economy’s health has improved, so has the ability of homeowners to afford larger mortgages. There have been plenty of instances this year in which a borrower has sold a home and purchased another, which results in the first mortgage being prepaid in full. That creates cash flow for the investor of the pool in which that loan resided.
Another factor is the (no surprise here) flattening of the yield curve. Although short-term interest rates have risen, and are at their highest levels in a decade, the longer durations have not kept pace, so that posted mortgage rates for both 15- and 30-year loans are still at affordable levels. As of this writing, 15- and 30-year posted rates are about 4.00% and 4.50%, respectively. The combination of these two factors has kept housing turnover, and thus prepayment speeds, very stable.
The two largest cohorts of the 15-year agency MBS market are the 2.5 percent and 3.0 percent coupon pools. They represent about 75 percent of all outstanding 15-year securities, which are staples of a community bank bond portfolio. These pools are collateralized with loans whose borrowers’ rates are not “in-the-money” to be refinanced, so there is almost no prepay activity going on at the moment related to refis.
In spite of this, prepayment experience has been surprisingly (and pleasantly) fast. The “speeds” for 2.5 percent pools have run about 9 percent consistently for the last 12 months. The 3.0 percent cohort, which should be a bit faster, has averaged about 10 percent in the same period. While it’s correct to conclude these speeds aren’t fast in absolute terms, they at least haven’t dwindled to a snail’s pace. And any amount of seasoning improves the paydowns even more, since the scheduled principal reduction on a 15-year pool begins to pile up pretty quickly.
Portfolio manager’s best friend
The benchmark “default” rate for mortgages to prepay is about 6 percent annually. This is the number of loans that turn over each year for reasons unrelated to interest rates. So another way to look at the recent performance of these 15-year pools is that prepayments are 50 to 70 percent higher than the benchmark. In an environment in which community banks are clamoring for cash flow from their bond portfolios, these securities meet that need.
Two other points to keep in mind. First, the average lives of these instruments are going to be in the 5-year range at the outset, which is in the sweet spot for a lot of portfolio managers. The average life will gradually shorten as these pools season. Secondly, both of these cohorts are currently priced below par, so the opportunity exists to average down your book values, since they were trading at premiums over most of the last decade.
Credit quality, liquidity, reasonable yield. Did I mention stability of cash flow?
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MBS performance history
ICBA Securities’ exclusive broker Vining Sparks publishes mortgage market prepayment commentary each month, including tables on recent performance for some of the more popular MBSs. Visit viningsparks.com or contact your Vining Sparks sales rep for more details.
Jim Reber is president and CEO of ICBA Securities and can be reached at (800) 422-6442 or email@example.com.